Emerging markets poised for better performance

ASX Investor Update asked Josh Hall of Aberdeen Asset Management about the outlook for shares in emerging markets, which have unperformed developed markets in the past five years.

(Editor’s note: Do not read the following ideas as stock or sector recommendations. Do further research of your own or talk to a licensed financial adviser before acting on the themes in this story).

ASX Investor Update: What are the features, benefits and risks of investing in emerging markets (EM)?

Josh Hall: The benefit of allocating some of your portfolio to EM is that you are investing in regions, countries and companies that can experience higher rates of economic growth relative to most countries in the developed world. All else being equal, this should lead to higher investment returns over time.

However, EM is not without risks. Political systems can be less stable, currencies more volatile, corporate governance less developed and transparency can also be more opaque. These risks can lead to more volatile investment returns since performance can be uncorrelated (weak relationship) to developed markets.

Many of the companies we invest in within EM are household names in their own markets – they are the Commonwealth Banks or Woolworths of their respective markets – and therefore often have dominant market positions and can provide attractive returns.

EM have been heavily sold off in the past 12 months amid rising fear about their prospects. Is this the time to be adding to EM portfolio exposures?

Josh Hall: The selloff in EM has not been as heavy as some people perceive. In local currency terms, the MSCI EM Index (a key barometer of emerging markets performance) has returned -5.4 per cent over one year to 31 December 2015. However, in US dollar terms the same index is down -14.6 per cent for the same period. That tells us this has primarily been an issue of US dollar strength rather than EM weakness.

The returns achieved by Australian investors (measured in Australian dollars) in the same index over the past three years have been 5.35 per cent per annum to 31 December 2015. While this is modest, it isn’t terrible. The driver of this has been the strong underlying economic performance of these countries compared to the more benign growth environment of most of the developed world.

We believe the risks EM currently face are already priced into valuations, making EM relatively attractive at these levels. So we think the current volatility now represents a relatively attractive entry point for long-term investors. To paraphrase a well-known quote from Warren Buffett: “Be greedy when others are fearful, and be fearful when others are greedy.”

What have been the main factors driving EM lower, and what do you see as the biggest risks over the next 12 months?

Josh Hall: The three main factors currently driving EM are the slowdown in China, rising US interest rates and a strong US dollar, and the slowing of corporate earnings growth.

Comparatively, the Chinese economy is still growing strongly, officially at somewhere between 6.5 and 7 per cent per annum, but this is a lower rate of growth than China experienced for the last decade when it averaged around 10 per cent. Its economy is transitioning from being heavily dependent on investment and export-led manufacturing to becoming more reliant on domestic consumption. This is a sign of the economy maturing and should result in more sustainable economic growth over time.

Second, in late 2015 the US Federal Reserve finally started to lift interest rates and the anticipation of this has resulted in the US dollar strengthening considerably. Historically, a strong US dollar has been a headwind to EM for a variety of reasons. However, expectations around how high US interest rates will rise are moderating quickly. All this means the impact on EM of higher US interest rates and dollar is likely to be less than the market is currently pricing in.

Finally, the rate of growth of company profits around the world has been moderating, particularly for energy and materials companies because of commodity price weakness, and this has had an impact on commodity-reliant economies. However, earnings growth within EM, excluding commodities, in local currency terms is still double-digit, which is very healthy and well above developed market peers.

What will be the big drivers of EM returns over the next five years?

Josh Hall: The underlying fundamentals for most EM countries remain relatively strong. These economies are experiencing higher levels of growth driven by the tailwinds of favourable demographics, rapid urbanisation and the increase in domestic consumption-led growth.

While we are cognisant of these top-down thematic forces, we are not macro forecasters. Instead, our investment approach is focused on bottom-up, company-specific fundamental research; we think this is the biggest driver of company performance over time.

After several years of underperformance, could EM outperform developed markets over the next five years?

Josh Hall: Mean reversion is a strong force in financial markets so there is some merit in that argument, although we would caution against relying on it solely. We prefer to form our views based on company fundamentals and, based on these metrics, EM looks relatively attractive to us.

The level of indebtedness most of the developed world now finds itself in after years of loose monetary policy will likely be a headwind to their future economic and stockmarket performance. Conversely, EM sovereign balance sheets are relatively stronger, the underlying economic fundamentals are positive and stockmarket valuations are at historically cheap levels.

Where do you see the best opportunities within EM?

Josh Hall: Our investment process is focused on researching individual companies and their specific fundamentals, so we don’t tend to invest based on regional, country, sector or thematic views. We build portfolios on this “bottom up” basis but we do ensure adequate diversification across region, country and sector because we try to avoid over-concentration in any one area of the market.

In terms of sectors, we generally see financials as being a good way to gain exposure to the underlying economic fundamentals of a country via, say, banks that lend to various areas of that economy.

Some of our largest country positions in our EM portfolios include India, Mexico and Hong Kong. Although not an EM itself, we see Hong Kong as a better access point to the China story given it has more transparent, mature and better-regulated capital markets.

We are cautious about investing in mainland listed Chinese equities as we believe the market is relatively immature and many companies lack transparency and proper governance. The extreme volatility in the Chinese equity market over the past few years has vindicated this decision, in our view.

How do forecast valuations for emerging markets compare to developed markets?

Josh Hall: Across a wide range of valuation metrics, EM stockmarkets currently look attractive against both their own historical valuations and developed stockmarkets around the world.

A common valuation metric is the historic price-to-book ratio, which is the ratio of the share price of the company to the historic book value of its assets. The MSCI EM Index has traded on an average price-to-book over the past 10 years of 1.9 times. At 31 December 15 this ratio was 1.4 times. In other words, EM were trading 28 per cent cheaper than their own long-term average.

If we compare this to other developed markets, EM also look relatively cheap. The price-to-book ratio of the US equity market at the same time was 2.8 times, or twice as expensive as EM. While EM typically trades at a discount to the US market, this current gap is a historic high.

Should investors focus on specific areas within EM?

Josh Hall: We believe that emerging markets, by their very nature, are less efficient than developed markets and this creates opportunities for an active investment approach to outperform indices. Historically, the Aberdeen Emerging Opportunities Fund has outperformed the MSCI Emerging Markets Index by more than 3.2 per cent per annum over the 10 years to 31 December 15, after all fees. We have high conviction that active management works within EM.

About the author

Josh Hall is an investment specialist in Aberdeen’s Australian business. He works closely with the global, Asian and emerging market equity and multi-asset teams to ensure local investors remain informed of Aberdeen’s current views and positioning.

From ASX

Aberdeen Asset Management is a foundation member of mFunds. mFunds are unlisted managed funds you can invest in through ASX’s mFund Settlement Service.

This article appeared in the March 2016 ASX Investor Update
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This article appeared in the March 2016 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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